Markets have sold off on fears of excessive tightening amid surging inflation. However, a soft landing is still likely given the strong starting point for the economy and likelihood of some breathing room from central banks in the second half of 2022 as inflation moderates.
On the May PGIM CIO call hosted by PGIM Quantitative Solutions, chief investment officers and senior investment professionals from PGIM's international businesses, PGIM Fixed Income, and PGIM Quantitative Solutions discussed prospects for the global financial markets amid a backdrop where global central banks seem to have a singular focus on combatting inflation and engineering a soft landing for the global economy.
Concerns about a recession have risen as inflation continues to surge and the Federal Reserve (Fed) and other central banks rush to frontload policy tightening. Markets have sold off sharply, with volatility spiking and nearing historically high levels on concerns that excessive policy tightening would choke off growth in attempting to moderate inflation. With inflation remaining elevated in Q2, the key question is whether major central banks will be successful in their plans to tame inflation by tightening policies just enough, without pushing the global economy into a recession.
The global economy remains solid, still supported by strong fundamentals, although recent economic data have been mixed. Risks to growth remain on the downside with ongoing conflict in Ukraine and rising COVID infections resulting in renewed lockdowns in China. Economic activity slowed in Q1 amid rising costs and supply disruptions following Russia's invasion of Ukraine. Global growth expectations have generally been marked down since the beginning of the year, especially for Europe, which has closer linkages and impact from Russia/Ukraine. US GDP fell 1.4% annualized in the advance Q1 estimate, the first decline since Q2 2020. Consumption was strong and business spending was robust, but imports and inventory have been drags on growth. Overall, the US economy remains solid, but the data are mixed. While the Fed's tightening policy to combat surging inflation has increased the probability of a recession in the next 12-18 months, the call participants still don't see a recession as a base case and expect a moderate growth trajectory consistent with a soft landing.
However, the impact of the war in Ukraine is expected to remain a drag on Eurozone growth. While Eurozone Q1 growth was in line with expectations at 0.8% QoQ, there have been significant downgrades to Q2 and Q3 growth expectations with rising energy costs and disrupted supply chains. With the ECB concluding asset purchases and set to hike rates later in the year, tighter monetary policy will likely be a drag on growth. Japanese GDP is expected to decline modestly in Q1, around 0.5%, with rising energy costs and the impact of COVID restrictions. However, growth is likely to improve as COVID restrictions are eased. Emerging markets (EM) growth expectations have been revised lower given the impact of the Ukraine war and slowdown in China. Emerging markets growth is expected to slow to around 3.8% YoY in 2022 after robust 7.1% growth in 2021.
Global inflation remains elevated although call participants think the worst is behind us, with moderation expected over the rest of the year on the back of base effects and declining goods prices. Developed market (DM) inflation is expected to pick up to around 7% in Q2 2022 from 5% in Q4 2021. While emerging markets inflation is expected to average a bit lower at 6.5% in Q2, it is expected to be stickier over the rest of the year. US inflation has eased a bit to 8.3% in April from 8.5% YoY in March. However, core inflation increased 0.6% MoM, a sharp pickup from March's 0.3% gain, providing a sign of broad-based inflationary pressure. Eurozone headline inflation was unchanged at 7.5% YoY in April, though core prices continued to rise to 3.5% from 3% previously. Japanese nationwide inflation increased to 1.2% YoY in March from 0.9% previously. Developed market inflation remains elevated due to the shock in oil and food prices following Russia's invasion of Ukraine as well as supply constraints. While current inflation readings remain quite elevated, call participants expect inflation to moderate over the second half of the year, providing developed central banks room to moderate their policy tightening.
On the policy front, the Fed and other major central banks are currently focused on tightening monetary policy in a bid to tame inflation, which surged beyond their earlier expectations. The Fed raised policy rates by 50 basis points (bps) in early May, bringing the target range to between 0.75% and 1%. The Fed also detailed its balance sheet reduction plan, initially reducing it by $47.5bn per month before increasing the drawdown to $95bn per month after three months. The ECB meeting in mid-April confirmed that they would conclude asset purchases in Q3 with hikes to occur sometime after that. The BoJ remains an exception, making no changes to their current policy stance and framework at their late April meeting. Central banks in EM continue to raise rates to rein in inflation as most central banks are facing inflation rates above their target range. The latest surprise came from India, which hiked unexpectedly in April. While the Fed is trying to frontload policy tightening measures in a bid to tame inflation, call participants believe that it might not have to implement as much tightening as the market currently expects, with inflation moderating over H2 2022, thereby engineering a soft landing for the economy.
Overall, call participants noted the worst might be behind us after the extreme volatility that has gripped financial markets in the past few months, and are incrementally optimistic given the chances for a soft landing of the economy. While the odds of a recession have gone up recently, the base case is still for the economy to avoid a recession. Inflation has surged, and central banks are determined to tame it. However, if inflation moderates and declines from the current elevated levels by year end, the Fed may do less damage than is currently feared. We could still get another leg down in stocks with the concerning Russia-Ukraine situation and China growth worries, but the VIX at 30 is already at historically elevated levels. Valuations have improved and given the still solid macro backdrop, we will likely see interest in risky assets picking up as rates stabilize. With rates in the 3% area and with spreads (Investment Grade & High Yield) wide, there is good value in fixed income markets, presenting a much more attractive nominal rate environment at current levels. Eventually, inflation will come down, which will help real returns as well.